Gold, dollar, and the yield
curve

My last article was titled
"The
good, the bad, and the ugly". It was about gold, the
dollar, and the Euro. The article stirred up a lot of interests,
and I have received a great deal of emails, from average folks
and from academics. There are many opinions and theories offered
by the experts as to the inter- market relationship between gold
and the dollar, and it is not my intention to involve in such
a debate, simply because I am not smart enough, not to mention
it gives me headaches if I spend too much time dwelling on the
subject. What was interesting though, was a self proclaimed economist,
asking me why it was that I thought gold and the dollar could
rise together. I don't know why, I'm just telling what I see,
I can guess I suppose, like everyone else. Obviously this economist
is not believing what he sees, that is why he is an economist.
He also mentioned inflation and deflation, disinflation and hyper-inflation,
ouch, my head is hurting already... Just because I see something,
doesn't mean it is visible to others. And by sharing my findings
with others, and reading others' findings, we become more objective
and learn from one another.

Today's article is a follow up.

The yield curve

To me, the most important factor
driving the financial markets is interest rates. The cycles of
rising and falling rates affect every aspect of business, and
the cost of doing business. But what is more important to me,
is the yield spread. Specifically, the yield spread between the
30 year bond and the 3 month T bill. I'm sure most folks are
familiar with the term "carry trade". That is the term
to describe taking advantage of the difference between the long
and short term interest rates. When the spread is wide, we have
a steep yield curve, by borrowing short and lending long, the
carry trade makes a killing. But when the spread narrows, we
have a flat yield curve, and there is little or no money in the
carry trade.

Here we see the yield curve
began to rise in 2001, to late 2003, then dropped like a rock
since. This is the direct result of the Feds lowering short term
rates from a series of events beginning with the tech crash and
then 9/11, and as short rates fell at a rate faster than long
rates, the yield curve steepened. Then the Feds began to tighten
by bumping up short rates, with long rates still falling, it
didn't take long for the yield curve to flatten again. We have
heard just recently a rumor that some large hedge funds might
have been in trouble due to their heavy exposure in the carry
trade, enough to give the market a quick hiccup. Hedge funds
obviously benefit from a rising yield curve, and so does gold.

There is no question that the
steepening yield curve has helped the rise in bullion from the
bottom of 2001, but the collapse in the yield spread did not
send gold back into a bear market, why? When we talk about the
price of gold (POG), we are talking in terms of US dollar. Therefore,
the weakness in the dollar was enough to keep gold in a holding
pattern since 2004, the price practically unchanged from Jan
2004 to today, well in the middle of a trading range between
$380 and $450 US.

As my previous article suggested,
the dollar is now in a bull market, then why is gold not falling?
My speculation is that market makers are already expecting the
yield curve to rise once again. This can be achieved by either
lower short rates, or rising long rates, or a bit of both. As
to why, I'll leave it to the economists. Therefore, from my technical
perspective, I see the possibility of the dollar and gold rising
together. The strengthening of the dollar is more influenced
by foreign currencies than interest rates.

Foreign currencies have an
inverse relationship with the dollar, simple as that.

This article was written
on June 12, but I have to wait until market close on June 13,
to confirm the last piece of the puzzle.

$TYX - the long bond yield
indeed broke out for a buy signal today as expected, therefore
confirming what market players were anticipating : the bottom
of long rates. And if long rates rise faster than short rates,
the yield curve steepens once again and the carry trade can breathe
a sigh of relief, and that is why gold and the dollar are rising
together.

Summary

Inter-market relationship is
very intricate, and like all markets, are subject to constant
change, and therefore, does not need to be predicted or forecasted,
just followed. What is promising though if you are a gold bull,
is that the combination of a steepening yield curve and a rising
dollar could be very beneficial to the POG. A steepening yield
curve is the main ingredient, and a rising dollar means falling
Euro and most other foreign currencies; and when the foreign
currencies fall, the POG in these falling currencies will rise.
That is when finally the POG rise against all currencies, and
that is when gold will finally be in a real bull market, a global
gold bull market, not just a US gold bull market as it has been
the past four years.

Remember, analysis is nothing more than an educated guess, do
not trade based on anyone's analysis, trade only according to
price action.